Equity fund v/s Debt Fund: How to choose to achieve financial freedom?

Equity funds are funds that predominantly invest in equities or equity-related instruments. These funds are considered riskier as compared to debt funds. Within equity funds, there are several categories and if you take a closer look at their portfolio you will see the difference between them.

Debt Funds or Debt Mutual Funds significantly invest the money in fixed-income securities like government securities, debentures, corporate bonds and other money-market instruments. These funds lower their risk by investing in such avenues. These products carry the least amount of risk when compared to other mutual fund investments. They have low volatility and generate modest returns over time.

The portfolio of debt funds has specific maturity ranges. For example, a liquid fund can buy only securities when having maturities of up to 91 days. They do not offer assured or fixed returns, unlike FDs. Their returns can fluctuate. A rise in interest rate has a positive impact on the interest income but a negative impact on the bond or instrument price. And it’s the other way round when the interest rates fall.  

Taxation

In equity mutual funds, the gains made are subjected to Short Term Capital Gains Tax and Long Term Capital Gains Tax, if your gains are more than Rs.1 lakh a year. If they exceed and you choose to liquidate your investment within a year, then you will be subjected to Short Term Capital Gains (STCG) which is 15% of the gains made. If you choose to liquidate after a year then you are subjected to Long Term Capital gains (LTCG) which is 10% of the gains made.

Like Equity Funds, Debt Funds are also subjected to capital gains tax which is Short Term Capital Gains Tax (STCG) & Long-term Capital Gains Tax (LTCG). If Debt funds are held for less than 3 years then STCG is levied and if more than 3 years then LTCG is levied. Presently the LTCG levied is 20% with indexation and STCG is taxed as per the investor’s tax slab. If the Income Tax Slab of the investor is 20% then the same will be levied on the Debt Funds gains in the case STCG.

Indexation Benefits

Equity funds do not offer any indexation benefits.

Indexation is a tool which is applicable to long-term investments. It helps an investor to adjust inflation while gauging the returns of the invested amount. There are several mutual fund investment calculators available online which help you calculate the indexed investment amount as per Cost Inflation Index (CII).

As inflation is gradually rising, what’s worth Rs. 1000 could be worth Rs.1100 sooner in near future. Thus, inflation is reducing the purchasing power of our money. The same amount will be enabling the investor to buy lesser and lesser goods. 

In the case of debt funds, we arrive at capital gains after indexing the purchase price of the mutual fund investment plan. When subjected to indexation, it lowers the long-term capital gains tax which brings down your taxable income. Indexation is the reason why debt funds are looked up to as a fixed-income investment option.

Both the types of mutual fund investments have their pros and cons. You will need to check which one among them suits your risk-taking capacity. If you need exposure to both, you may take a look at Balanced funds. If you have invested in an equity mutual fund and you are nearing your goal, you can make a systematic withdrawal plan (SWP) to debt fund. As equities are more volatile, so you should take care to see that your investment value does not reduce when you are at the peak of reaching your goal.

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Mutual Fund investments are subject to market risks, read all scheme related documents carefully.